Market Intelligence: China growth uncertanties

08 February 2013 10:02[Source: ICB]

Stock markets and oil and petrochemical prices have rallied since the New Year, partly on a belief in a sustained recovery in China GDP growth during 2013. But there are plenty of reasons to believe that the recovery may not be sustainable.

Evidence at the ground level, in the polyolefins business, is at best mixed over whether there has even been a strong improvement in demand in China.

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Some pessimistic producers fear that the rebound is limited to a few converters in need of prompt material before the Lunar New Year, which falls on 10 February, and temporary supply tightness.

Southeast and northeast Asian integrated high-density polyethylene (HDPE) margins indicate that producers, at least until the second week of January, lacked pricing power despite the very tight market.

Part of the explanation could be that problems persist for China's 12.4m small and medium-sized enterprises (SMEs), which, according to the government newspaper, the China Daily, account for 50% of income tax payments, 60% of GDP and 80% of employment.

The SMEs are paying interest rates of 15% via China's shadow-banking system. Bank loans from the state-owned lenders meet only 20% of the financing requirements of smaller companies, the China Daily said in a 17 January article.

Rising fuel costs, as a result of more expensive oil, are likely to have exerted further pressure on the SMEs. Prices for gasoline and diesel remain near record levels in China, around 40% higher than during the previous peaks in the summer of 2008 when prices were capped to prevent social unrest during the Beijing Olympics.

This creates a threat to consumer demand in a country where the majority of people earn less than $10 a day (people on low wages spend a bigger proportion of their incomes on fuel and food than the wealthy). Labour costs are also set to rise even further this year, because of tight labour markets and government-driven efforts to narrow the gap between rich and poor.

In 2012, the number of working-age people in China decreased by 3.45m to 937.27m, according to the National Bureau of Statistics (NBS). The country's demographic dividend is beginning to fade due to the one-child policy.

Rising labour costs could further squeeze margins for the SMEs and accelerate the closure of low-value manufacturers in China's more developed eastern and southern provinces. And, if China's new leaders are serious about cleaning up the environment following the air pollution crisis in Beijing in mid-January, environmental compliance costs will increase, with factories that fail to meet more stringently-enforced rules closed down.

The root cause of the expected rebound in first quarter GDP growth also suggests that the recovery may not be sustainable. State-directed bank lending surged in May-October 2012 as the central government attempted to shore-up support ahead of the once-in-a-decade leadership handover in November. Some $1,100bn was allocated for infrastructure investments.

Some of the extra money may continue to percolate through the economy during the first half of this year, but the process of withdrawing stimulus has already begun. Inflation has also become a problem again, as in December overall inflation reached a seven-month high, driven by a steep rise in real estate and food costs. This is likely to make the government cautious about further stimulating the economy if the government is to hit its target of annualised inflation of 3.5%.

And the fact that infrastructure spending and a rebound in the real-estate sector have driven the recovery casts further doubt on its sustainability.

HSBC says that investment growth is making the biggest contribution to growth since 2009 - the year that China injected $640bn into the economy to compensate for the global crisis.

December's retail sales rose by 15.2%, to an eight-month high. But UBS argues that the strong figure was largely the result of an increase in property transactions and spending on furniture and household goods. China's average annual urban disposable income in 2012 was yuan (CNY) 24,565 ($3,943). Home prices, meanwhile, averaged CNY 20,700 yuan per square metre in Beijing, according to Reuters.

China's new leaders have given every indication that they will forge ahead with rebalancing the economy - a job probably made a lot harder by the politically-motivated economic stimulus of May-October last year. Official statements emphasise more balanced growth.

The task has been given extra urgency as a result of rising public discontent over income inequality, air pollution, food contamination and corruption amongst top government officials. Beijing has made it clear that it will be happy with GDP growth of 7-8%, far below the peak of 14.2% in 2007, as the investment growth model - responsible for all the above problems - is dismantled. But the problem is that the economy has become heavily dependent on investment as a driver of growth and so GDP growth during the adjustment process even lower than 7-8% seems a possibility.

Peking University finance professor Michael Pettis, in a 28 December 2012 post on his China Financial Markets blog, said that China needed to at the very least reduce investment as a percentage of GDP growth to 40% - from around 50% in 2012 - over the next five years.

"Chinese investment must grow at a much lower rate than GDP for this to happen. How much lower? The arithmetic is simple," he wrote in the same blog post.

"It depends on what we assume GDP growth will be over the next five years, but investment has to grow by roughly 4.5 percentage points or more below the GDP growth rate for this condition to be met.

"If Chinese GDP grows at 7%, in other words, Chinese investment must grow at 2.3%. If China grows at 5%, investment must grow at 0.4%. And if China grows at 3%, which is much closer to my ten-year view, investment growth must actually contract by 1.5%."

Fixed-asset investment grew by 20.7% in 2012, which puts the scale of the adjustment in perspective.

And there is another wild card in the pack that could severely damage global, as well as Chinese, economic growth: the risk of a war between China and Japan.

The two countries are at loggerheads over the ownership of the Diaoyu/Senkaku Islands in the East China Sea. China's new leaders could have adopted an aggressive stance towards Japan in an effort to deflect attention from economic problems at home, say many commentators.

As a result of all of these uncertainties, companies must no doubt be building into their scenario planning another sharp decline in China demand growth. They might also be looking for new opportunities in China linked to the efforts being made to change the country's growth model. For example, there could be huge opportunities in helping China clean up its environment.